Your Money: Tips on buying corporate bonds

Corporate bonds are grabbing the spotlight these days as investors grow desperate for yields above rock-bottom U.S. Treasuries, which are returning just 3 percent or so annually.

We asked one reader, Karl O. Koch, to allow us to reprint his question: How does one go about buying corporate bonds?

We'll show you the ways to buy individual corporate bonds and bond funds, the pros and cons of each, and the fees to watch out for.

Retail investors can research company bonds' risk via credit ratings. The three main agencies are Standard & Poor's, Moody's, and Fitch, as well as independent credit ratings services Rapid Ratings or Egan-Jones. S&P, for instance, rates "investment grade" corporate bonds at BBB or above; below that are known as "high yield" corporates, or junk bonds.

The higher the rating, the less risk, at least in theory. But a lower rating means potentially a higher yield - since that can result in a higher cost of borrowing. Understanding the security or collateral pledged against the obligation as well as the credit quality of the underlying issuer is key.

Think of a corporate bond as an IOU, money that companies borrow from investors at a specified interest rate over a specific time period. A good place to start tracking corporate bond prices and yields is on Bloomberg's website (http://www.bloomberg.com/markets/rates-bonds/corporate-bonds/). The FINRA/Bloomberg Active U.S. Corporate Bond Indexes are comprised of the most-often-traded corporate bonds, and these indexes can help you compare returns among them.

Investing in a high-yield corporate bond fund? Then it should have returned at least 4 percent in 2011, compared with the benchmark indexes Barclays Capital High Yield and Merrill Lynch High Yield Master II, which rose in the 4 percent to 5 percent range last year.

When examining historical performance of an individual corporate bond or fund, the most important measure is "total return," not just the amount of income the bond generates. Total return measures the amount earned by owning a security over time, incorporates the accrued interest on the bond during ownership, and coupons paid out on the bond. Total return is the most complete measure of money made.

Jeremy Brenn of Sensenig Capital Advisors in Fairview Village, Pa., says his firm mostly advises clients to buy bond funds like DFA Two-Year Global Fixed Income Portfolio (DFGFX), with a low, 0.18 percent fee annually. The fund typically keeps maturities very short and credit quality high so as not to take on undue risk. Short-term corporate bonds generally mature within three years, medium-term is up to seven years, and long-term is generally up to 30 years.

The fund's returns haven't been great recently, with one-year at 0.78 percent, 3-year returns at 1.5 percent and 5-year at 2.8 percent, but "we think of the bond side of the portfolio as a way to temper the volatility of the stock side. Therefore, we educate clients about a 'total return' approach to investing rather than focusing purely on income," as many investors do.

However, Sensenig Capital also purchases individual bonds in large-cap A-rated companies such as PepsiCo and GE Capital for clients' portfolios. They use the Vanguard Short-Term Bond ETF (symbol: BSV), which has a tiny 0.11 percent fee.

The advantage of bond mutual funds is they are more easily traded than individual bonds. Among some of the more well-known are: the iShares iBoxx High Yield Corporate Bond Fund (HYG) or the PIMCO Investment Grade Corporate Bond Index Fund (CORP). There are also fixed versus floating-rate bond fund options. Van Eck was among the first to provide an investment grade-rated, floating-rate corporate bond ETF, which offers a play on the direction of interest rates; if rates go higher, then the floating-rate bonds return more.

Guggenheim Bulletshares also offers corporate bond ETFs that vary based on bond maturities all the way out to 2017 (BSCH).

Exchange-traded funds are another option, but be aware some bond ETFs are not as tax efficient as once thought.

Remember, you can calculate the total return yourself for a mutual fund, an ETF or a corporate bond, either by contacting the fund firm, checking the fund on Morningstar, or the fund's website.

Finally, buying corporate bonds individually is an option - but retail investors may have trouble buying in small lots. Some companies let you buy directly by contacting the investor relations department. If they don't, call your discount or other brokerage firm and buy over the phone, or online via your brokerage account.

It's key to check at what price and when the bond has traded before making your purchase, to avoid getting a marked-up price. Bond traders are notorious for marking up prices to build in unnecessary commissions.

Again, FINRA's website has good recent price data (http://cxa.marketwatch.com/finra/BondCenter/). For instance, local utility company Exelon's June 2035 bonds (EXC.JL / CUSIP: 30161NAC5) yield 5.08 percent with a semi-annual coupon, according to www.finra.org/marketdata.